Saunders & Cornett, Financial Institutions Management, 4th ed. 1 “Wall Street is a street that begins in a graveyard and ends in a river.” Anonymous.

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Presentation transcript:

Saunders & Cornett, Financial Institutions Management, 4th ed. 1 “Wall Street is a street that begins in a graveyard and ends in a river.” Anonymous

Saunders & Cornett, Financial Institutions Management, 4th ed. 2 Interest Rate Risk The impact of unanticipated changes in interest rates on the FI’s market value. Arises from mismatched maturities. FIs typically issue longer term assets to finance funds deficit units and obtain shorter term liabilities to offer claims to funds surplus units. So: typically FIs face refinancing risk – the risk of rolling over borrowed funds over the longer life of the asset investment.

Saunders & Cornett, Financial Institutions Management, 4th ed. 3 Market Risk The impact of unanticipated changes in exchange rates, securities prices and interest rates on the FIs’ market value. Interest rate risk can be considered a subtopic under market risk. Arises in both the trading book and the more stable banking book.

Saunders & Cornett, Financial Institutions Management, 4th ed. 4 Credit Risk The impact of unanticipated changes in cash flows on the FIs’ market value. McKinsey estimates that 60% of FIs’ risk emanates from credit risk exposure. Loan charge-offs: deduction for lack of repayment of either principal or interest.

Saunders & Cornett, Financial Institutions Management, 4th ed. 5 Operational Risk Risk of loss caused by failures in operational processes or the systems that support them, including those adversely affecting reputation, legal enforcement of contracts and claims. Includes strategic and business risks. Not limited to technology/backoffice failures. Example: Arthur Andersen’s shredding of Enron documents. Catastrophic operational risk can end life of firm.

Saunders & Cornett, Financial Institutions Management, 4th ed. 6 Off-Balance Sheet Risk The impact of unanticipated shocks resulting from contingent assets & liabilities May be due to credit risk – ex. Default triggers letter of credit guarantee or perfomance bond. May be due to market risk – ex. Exchange rate or interest rate swap payments. May be due to operational risk – ex. Cat options.

Saunders & Cornett, Financial Institutions Management, 4th ed. 7 Other Risks Country or Sovereign Risk: repayments from foreign borrowers and access to foreign assets may be blocked by foreign governments. (ex. Argentina’s 2001 default) Liquidity Risk: Sudden surges in liability withdrawals may require losses as FI liquidates illiquid assets at firesale prices. Insolvency Risk: Capital may be insufficient to absorb losses due to other risk events. Interaction across Risks